Vuk Vukovic is a lecturer at the Department of Economics, Zagreb School of Economics and Management (ZSEM), where he teaches Political Economy and Principles of Economics. He received his Master of Science degree from the London School of Economics.
With the West going through a slow recovery due to the effects of an enduring financial crisis and a slow deleveraging process (some have called this the Reinhart-Rogoff effect) there are still things policymakers can do. No, this does not imply more fiscal or monetary stimuli which will only result in restoring the pre-crisis unsustainable equilibrium. The focus of recovery policies should rest on several principles that can most easily restore the dynamism in the economy and consequently result in higher long-run productivity and higher wealth. These are innovation, investments, and trade.
Innovation refers to creating and sustaining new patterns of production and labour specialisation, and a focus on creating new business models which will adapt to the changing environment. Old inefficient jobs and industries need to be allowed to be replaced by new, more efficient ones. This switch was being held back for too long during the pre-crisis decade, a time in which technological growth and enhancements were partially responsible for creating the boom.
Firms failed to adapt to these changes and were misallocating resources. Politics was even more unresponsive as it often directly prevented the necessary adjustment. This is exactly why a decade long productivity shock in Europe and beyond was falsely interpreted as an aggregate demand shock on the housing market, which policymakers aim to solve by short-run interventions.
The problems facing the Western growth model were much deeper and much more structural. That’s why a focus on innovation is key; innovation that can help the market participants prevent future wealth shocks and productivity downturns by reacting to the changes in the business environment.
Investments, an important driver of growth, are held back due to a lack of money flowing in from both banks and cash hoarding businesses. Big businesses and banks tend to hoard a lot of cash (a total of $1.7tn is held by US non-financial companies, while banks have significantly increased their reserves, partially because of new capital standards). It’s easy to explain such behaviour - in times of low confidence and high policy uncertainty investors are risk averse and hold on to safe assets rather than invest into anything even slightly more risky. For banks these are reserves which are more attractive than any short-term bonds. Their credit activity is thus highly unlikely to be started by any targeting attempts like Project Merlin for example.
The answer lies in the only thing a government can do to restore confidence – reduce policy uncertainty to restore business optimism, and reduce any regulatory boundaries and costs that prevent firms from succeeding in the marketplace. Reducing costs will provide a much cheaper and more efficient alternative than any form of subsidies, whilst creating incentives for businesses to compete for customers, not political favours. An improved business environment, lacking many constraints piled up in pre-crisis times, and lacking policy uncertainty, will open up new entrepreneurship opportunities which will gradually induce banks to release more credit into the system.
Lessons to Europe’s economies
The situation in which the Western economies found themselves isn’t an isolated historical event. These situations happen quite often. The biggest difference is in the response to the shocks, or better yet, how the shocks are recognized. In the case of Sweden in 1992, Germany in 2003, or Estonia and Latvia in 2009, the faults of an old system were recognized and reformed. Whether this was an inflexible labour market, an inefficient tax system, burdensome regulations, or all three combined, the response was timely and efficient, and the results were a more sustainable growth model.
In terms of current fiscal consolidation attempts it is important that all the reforms be mutually supported by medium term budget plans which will send credible signals to attract investors.
But this is harder to accept in many European countries where its citizens got used to a comfortable social safety net which has altered their incentives of creating value and generating wealth. Electoral pressures make the necessary reforms all the harder to do, but even the voters realize that the system must be reformed. Drastic times require drastic measures. The focus on austerity was a wrong approach primarily because it was done the wrong way (favouring increased taxation and minimal spending cuts), and more importantly, institutional reforms which were supposed to reinforce the government cuts weren’t implemented.
Structural reforms to promote competitiveness, medium-term fiscal consolidation and a strong pro-business environment will enable the economy to pick up the momentum it needs to regain confidence and start growing again. No single policy aimed at short-term boosts will be of much help. Only a broad set of policies aimed at institutional reforms - like the ones done in the aforementioned countries - will signal greater confidence among businesses, consumers and the banks to innovate and invest in new ventures. Only then the true process of deleveraging can commence and new patterns of specialisation will emerge.